It might cost you $39K to crowdfund $100K under the SEC's new rules

On October 23, 2013 the Securities and Exchange Commission (SEC) issued the proposed rules for Regulation Crowdfunding.  The 585-pages included an explanation of the rules, the feedback it received, and a cost/benefit analysis.

A cost/benefit analysis is common in many regulations to give the public an estimate of the costs associated with implementing the proposed regulation.  It answers the question, “Do the costs outweigh the benefits?”  For Regulation Crowdfunding it sheds light on the question, “How much will it cost to raise money via crowdfund investing, and how do I keep it to a minimum?” Here’s a closer look at what that analysis tells us.

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The Background

The legislation requires that the selling of crowdfund securities take place on registered websites.  The websites hosting the transactions are known as funding portals or broker dealers.  These entities must register with the Securities and Exchange Commission (SEC) and the Financial Intermediary Regulatory Authority (FINRA).  The legislation mandates investors have access to a business plan, use of proceeds, a valuation of the company, and financials. Firm may need to retain a Certified Public Accounting firm to certify the company’s financials or audit the company’s books.  Every step costs money, from completing the required documents to retaining professional services to assist in compliance.

The SEC looked at 3 variables:

a) the success fee (in terms of a percent (%) of proceeds) paid to websites for facilitating the transaction,

b) the compliance cost related to the preparation and filing of individual forms both during and after a campaign, and

c) the costs for a Certified Public Accountant (CPA) review or audit (an expense that scales over $100,000).  Certain costs like the success fee as a percent of the raise are variable, others scale like the CPA/Audit costs for raises over $100,000 and others like the compliance costs are fixed.  The SEC provided both low and high estimates for these costs based on assumptions and surveys it took.

For raises under $100,000, the SEC estimates portal and compliance fees will eat up between 12.9% and 39% of the money raised. For raises over $100,000 but less than $500,000, that figure may drop down to 7.96%.  And for raises over $500,000 but under $1M, it may drop to 7.66%.

For those of you who just want to see a graph, my team at Crowdfund Capital Advisors plotted that below. We decided to stick with industry estimates and make individual calculations for every extra $1,000 in capital sought. This is close to what it looks like:

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The Strategy

If you are looking to raise money via crowdfunding, the moral of the story is, try to raise as close to the next threshold as possible. The thresholds are at $100,000, $500,000, and $1M. So if you need to raise $60,000 for your business, aim for $99,000. Not only will you pay less for that money but you will have more of it. Of course, this assumes you will be able to secure $99,000 from backers. Same holds true for the $100,000 to $500,000 levels and over $500,000 level. While this was not the intent of the legislation (to force companies to seek more capital than they need), it may make sense when trying to decrease the cost of raising that money.

The Most Likely Scenario

The proposed rules allow entrepreneurs to do a crowdfund offering to unaccredited investors at the same time they do a private offering to accredited investors. This is called a parallel offering. Entrepreneurs who want product and market validation from the crowd, with more substantial capital (outside of the $1M cap in Regulation Crowdfunding), while skipping the full audit requirements required of raises over $500,000, will most likely do a $499k crowdfunding raise and seek the rest from accredited investors outside of Regulation Crowdfunding.

Sherwood Neiss helped lead the U.S. fight to legalize debt and equity based crowdfunding, coauthored Crowdfund Investing for Dummies and cofounded Crowdfund Capital Advisors, where he provides strategy and technology services to those seeking to benefit from crowdfund investing.